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Understanding Commercial Real Estate Debt

While many individuals understand the concept of a mortgage on a home, investors looking to allocate to commercial real estate directly or through a fund structure should consider the terms and risks of underlying debt when evaluating an investment decision. In addition, understanding real estate debt is one component of assessing if an offering fits the criteria based upon an investor's financial objectives. This article will simplify coverage and leverage ratios, highlight a few practical applications, and touch on nuanced debt topics.

Before jumping into details of real estate debt, we should first spotlight its position in the overall capitalization. While there are many ways to assemble capital to fund a transaction, total capitalization comprises debt and equity in the most basic form. Debt always receives preference from a payment priority from ongoing cash flow, if available, and upon a sale or recapitalization. Equity is how much property value above the loan remains, or said differently, total capitalization less debt.


Secured vs. Unsecured Debt

Now that we have a baseline understanding of the capital stack, debt can be categorized into two types, secured and unsecured.

A secured loan is when the borrower pledges the underlying real estate as collateral to obtain financing from the lender. If the owner or Sponsor cannot keep up on servicing the loan, or pay it back at maturity, then the lender has the right to take back the property and potentially sell it to recover some or all of the loan amount.

An unsecured loan does not use the property as collateral; instead it is based on the borrower's creditworthiness.

Should the borrower not pay the loan in either type of loan, the lender issues a notice of default to remedy. If there is no action over a defined cure period, legal action may ensue. Generally, interest rates on secured loans are lower as compared with unsecured loans.

Debt Service Coverage Ratio


Debt Service Coverage Ratio or "DSCR"

The debt service coverage ratio is a term used to compare the income of the property against its debt obligations. The formula to calculate DSCR is simply Net Operating Income divided by Debt Service.

Debt Service Coverage Ratio = Net Operating Income / Debt Service

For example, if the historical twelve-month net operating income, or “in-place NOI,” is $1,000,000 per year and the debt obligation required to service the loan is $750,000, then the property would have a DSCR of 1.33x.

Why is the DSCR ratio important? Many lenders require a 1.2x DSCR as part of the lending requirement for traditional loans. A DSCR of 1.0x means the property generates enough cash flow to cover debt obligations. If the DSCR is less than 1.0x, a lender may require the borrower to deposit and maintain a reserve and potentially offer a higher rate to compensate for the risk.


Loan To Value or "LTV"

In addition to evaluating DSCR, lenders use a loan to value ratios to assess risk and issue a loan. LTV is the ratio of the loan amount compared to the market value of the property. Banks take several approaches to determine the property's value, including an appraisal from an independent consultant, discounted cashflow analysis based on net income derived from the asset, or replacement cost. Ultimately, the LTV is used to evaluate the likelihood of paying back the loan if the asset is sold.

Loan-to-Value = Loan Amount / Asset Value

To illustrate this concept, assume a sponsor purchased an office building for $8,000,000 using a $5,000,000 loan and the balance paid in cash. The LTV is 62.5%.

A high LTV loan may exceed 75%. A high LTV loan means the sponsor is borrowing more money compared to the asset value. Thus, the lender could lose more if a default occurs and cannot sell the property for at least the loan amount. Typically, the higher the LTV ratio, the higher the interest rate offered by the lender.


Loan To Cost or "LTC"

The loan to cost, or LTC, is used to calculate the loan amount compared to the total construction or rehabilitation cost. In addition to the property value, costs may include material, labor, architecture, and engineering fees. Sometimes, the term LTC is used with short-term or construction loans.

Loan-to-Cost = Loan Amount / Total Cost

Let’s say the cost to purchase a multifamily property is $22,000,000. The sponsor plans to improve the exterior and renovate the units as leases lapse. The material cost, labor, city filing fees, and architect expenses are forecasted to be $5,000,000 in capital improvements for a total cost of $27,000,000 after renovation. If the bank is willing to lend $20,000,000, with the sponsor covering the balance out of pocket, the LTC is approximately 74%. Similar to loan to value, the higher loan to cost percentage, the higher the risk to the lender.

Real Estate Debt


Practical Considerations

Putting it all together to simplify real estate debt concepts further, let’s look at one final example. Assume a sponsor purchases a 15,000 square foot commercial property that needs improvement to bring rents to market value.

Property (Annual Historical 12 Month Figures)
Gross Rent $450,000
Operating Expenses $130,000
Net Operating Income
$320,000
Debt Service
$120,000
Property Capitalization & Debt Terms
Purchase Price
$6,000,000
Loan Amount
$4,000,000
Renovation Cost $950,000
Loan Rate (Fixed, Interest Only)
3.0%
Term
7 Years
Fundamental Debt Statistics
DSCR
2.67x
LTV
67%
LTC
58%


Our example shows that the property has healthy debt coverage and leverage ratios based on industry standards. Not only are DSCR, LTC, and LTC frequently used by lenders to measure risk, but are worth paying attention to when considering potential risks associated with investment decisions.


Another concept to understand downside protection from a lender perspective is called the “last dollar” basis. This term is the maximum risk exposure the lender is willing to accept. For example, in the case above, dividing the loan amount by the total square footage of the property yield a last dollar basis of approximately $267/foot. Thus, the lender should be confident in selling the property for at least $267/foot to recover the loan amount.


The Key Takeaways

When it comes to analyzing the risks of a commercial real estate investment, debt is one variable to consider. Comparing two offerings with identical leverage and coverage ratios, the asset type and geographic region might also be factors to contemplate when examining prospective investments.

By knowing DSCR, LTV, and LTC, you'll be better equipped to make more informed decisions to achieve a well-balanced portfolio that includes real estate.

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